Wednesday, January 09, 2008

Inflation/Deflation and Purchasing Power

A great debate rages about whether the future holds runaway inflation, Japan-style deflation, or stagflation. Every time I write about the notion of inflation and deflation co-existing, e.g. biflation, or stagflation, I am informed that inflation and deflation reflect only money supply, not price or supply and demand.

My problem with setting money supply as the defining measure of inflation and deflation is practical. This pronouncement leads to an obsession with measuring money supply rather than with the relative loss or gain of purchasing power.

Purchasing power, which reflects plain old supply and demand and the relative store of value of a currency or other money, matters more in the "lived" economy than money supply. In this view, both inflation and deflation are misleading concepts and should be set aside as such.

Look, if I'm paying more money and getting less goods/services in return, do I care if money supply (and what exactly is that? M3? M3-prime? Shall we argue endlessly about that, along with how many angels can dance on the head of a pin?) is expanding or contracting? No, I don't; if money supply is shrinking yet I'm getting less goods for the same money, then why aren't the cost of goods deflating?

If we're not allowed to call rising prices/loss of purchasing power "inflation," Then what the heck do you call it? Rising prices? Fine. Let's go with that. But please don't insist on calling rising prices "deflation." That is Orwellian nonsense of the highest order.

Wittgenstein warned against this kind of linguistic trickery, and the slipperiness of concepts which cannot truly reflect reality. If you live in Japan, as many of our friends do, then it gives cold comfort indeed to hear from some theorist that Japan is in deflation as you pay more for fuel and food than you did last year.

What does it matter to pronounce deflation if prices are rising? Because the land value in Niigata prefecture is declining? That's great if you're planning to pick up some agricultural property in Niigata (not as simple as it sounds for Japan-specific reasons too complicated to go into here), but what about Average Urban Salaryman's declining purchasing power? Do you see the completely absurd uselessness of the term "deflation" when purchasing power is in fact declining rather than rising?

In a truly deflationary setting, then my cash buys more next year than it does now. This was the case in the Great Depression. You could buy more food, more shelter, etc. etc. every year. Now that's deflation.

Pardon my skepticism when "deflation" is announced due to shrinking money supply yet prices are rising, i.e. purchasing power is declining, not rising. This makes a mockery of the concepts "deflation" and "inflation" which are a priori measures of price.

Rather than argue about measuring money supply, which I find particularly useless and distracting, let's revert to discussing supply and demand.

Let's say money is still available at low rates to qualified buyers for the purchase of a house. Is macro-measured money supply increasing or contracting? Who cares? If I want to, and I actually have a verifiable income and 20% down, I can buy a house-- and so can anyone else. That means money is available, regardless of its macro shrinking or expanding.

But what if I have no desire to buy another property? And let's say few others have any desire to do so, either. When demand is near-zero, the price of a good or service will fall even if money supply is expanding.

The reverse is true when money supply is contracting. If you need gasoline to get to work and supply is limited, you will line up at the nearest gas station and pay whatever price is demanded. Demand exceeds supply, hence prices rise, even if money supply is plummeting, i.e. "deflation" to those who insist that money supply is all that matters.

To pronounce "inflation" or "deflation" based on money supply rather than measuring purchasing power is to define an absurdity. You can pronounce this a deflationary economy until you're blue in the face, but if the actual living participants in the economy are suffering from a loss of purchasing power, your pronouncement makes no sense and has literally lost all meaning.

On the ground, a loss of purchasing power is not deflationary, regardless of what macro-money supply is doing. This is self-evident, isn't it? If we stop caring what ideological precept gets gored, then we can admit to the meaningless of "inflation" and "deflation" and focus on the meaningful reality of purchasing power.

Okay, let's move on to the complexities of purchasing power. If houses are dirt-cheap but no one can borrow money, then are the houses actually "cheap?" They are to people with savings, i.e. plenty of cash. But to those with little savings, then they are dear indeed. So which "reality" counts? The one for savers, or the one for borrowers?

If a haircut drops in price but your petroleum bill doubles, are you living in an inflationary or deflationary economy? Who cares? The reality is, you spend $500 a month on petroleum (say) and $25 on a haircut (okay, it's a Supercut), then are you wowed by the "deflationary" reduction in your expenses?

Bottom line: your purchasing power has taken a huge hit. Your $500 buys less petroleum products than it did last year. But hey, you moved to a much cheaper rental dwelling because rents are falling. Your purchasing power just increased; you bought the same shelter for less money. But oops, your $500 buys a lot less food than it did last year. Dang, another loss of purchasing power.

Let's say you transferred most of your cash savings into physical gold via Bullion Vault (see link on the right sidebar) last year when gold was $600/ounce. Now it's $890/ounce and you transfer some of your savings back into dollars. Woah, your savings increased rather handsomely in purchasing power.

Let's say you stuck a few bucks in a futures contract on oil or the OIL ETF last year when oil was $60/barrel. Hey, nice move, your cash gained in value as oil rose to $97/barrel; your purchasing power increased significantly.

2. let's focus on purchasing power, which can be measured in relative terms of currency but which really requires a much finer-grained analysis.

I know we all want a comprehensive answer to "inflation" and "deflation" and "purchasing power," but the reality is too complex for this sort of reductionism. If your U.S.-based (i.e. sales are earned in dollars) business takes you frequently to Europe, your purchasing power overseas has been absolutely decimated by the decline in the dollar.

But if you have a fixed-rate mortgage, you buy most of your groceries at ethnic markets and bulk goods at Costco or Wal-Mart, and your savings have been in a gold ETF, your composite purchasing power has either remained stable or increased.

Did you earn a nice bonus this year? hey, your ability to purchase goods and services rose. Did you receive a mortgage re-set in the mail this month? Dang, your purchasing power just decreased, because you'll be paying more now for the same shelter.

On a macro-level, these complexities render any assessment of economy-wide purchasing power essentially worthless. In other words, you're on your own in this economy. Regardless of official "inflation" or "deflation" of money supply, your purchasing power might rise or fall depending on a number of variables. Wages have in aggregate remained flat for years, so the "average" American family has suffered a decline in purchasing power which they have offset by removing the vast increase in their home equity via a HELOC (home equity line of credit) or re-finance.

Since this was "free money" (unearned), then didn't their purchasing power increase? If their monthly payment stayed the same, didn't they have more money to spend and hence an increase in purchasing power?

Oops, that was borrowed money. Dang, and so was all that money the state of California spent on those roads and benefits and other goodies, and all the goodies like a foreign war and Medicare Druggie Benefits the Federal Government paid for with borrowed money (the fastest rise in Medicare costs in 25 years--how do you like them cookies?)

At some point, complexity renders simplistic reductionist answers meaningless. If oil doubles in price to $200/barrel, and you're a tele-commuting one-car family driving an 8-year old Honda Civic that gets 35-40 miles to the gallon when driven with properly inflated tires and modest care, then exactly how great will be your reduction of purchasing power? $30 a month? So what?

And if the dollar plummets 50% but you buy very little from overseas other than from China, whose currency remains essentially pegged to the dollar, then as long as you don't travel outside the U.S., then how significant will your reduction of purchasing power actually be?

In conclusion: if you live a certain lifestyle, and make certain investments with your savings, then your purchasing power may decline with alarming velocity or remain essentially unchanged, or even increase, regardless of money supply increasing or decreasing. The choice is yours, and ideological pronouncements on "official inflation" or "money-supply deflation" will remain deeply and essentially a priori meaningless.

Readers Journal has been updated! An important new essay and many excellent comments on Can a Fragmented Culture Find Common Ground? and inflation/deflation.

Thank you, John B. ($21.12), for your generous support of this humble site. I am greatly honored by your contribution and readership. All contributors are listed below in acknowledgement of my gratitude.

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